Japan's Emperor has no clothes

Analysis: No crisis yet, but a minefield of policy decisions

By

BillClifford

Sinking markets and sputtering growth in the world's two biggest economies cast long shadows. Downturns in the U.S. and Japan, which together account for about 40 percent of world economic output, raise the specter of a global slump. And that breeds risks of trade protectionism in rich nations and stunted development in less-industrialized countries, both of which would further inhibit global economic growth.

Good policy makers and smart investors succeed by anticipating, assessing and minimizing risks. It starts with awareness.

Which is why it's bizarre that a warning from rating firm Fitch -- that it might downgrade its ratings of the financial strength of 19 of Japan's biggest banks -- sent bank shares and markets around the world into a tailspin. See full story.

Most people with more than a passing interest in international finance are aware that the precarious solvency of Japan's banking system is a decade-old problem. The banks have already written off a staggering 68 trillion yen ($560 billion) in non-performing loans. That they're still saddled with 30.4 trillion yen in bad loans is the root of Japanese economic woes: misallocation of capital and asset price deflation.

This didn't happen overnight, although the Fitch report seemed to kindle a new sense of crisis in the minds of international investors. To be sure, the recent drops to 16-year lows on the Nikkei Stock Average have intensified pressure on Japanese banks, threatening them with losses on equity holdings. Gains in these portfolios have been used to bolster their capital bases and to write off bad loans; the write-offs might cease if losses are accounted for instead, and if losses are big enough, some banks could conceivably fail.

But even if this were to happen, it still would be quite a leap to the worst-case scenario of a systemic banking meltdown and Japanese defaults on obligations to foreign creditors.

The broader Topix index of all issues on the Tokyo Stock Exchange's First Section closed at 1,183.79, about 21 percent above its low in October 1998. At this level, Osaka-based Daiwa Bank is in serious trouble. Daiwa, according to Commerz Securities' estimates, would have negative retained earnings of 125 billion yen -- meaning it wouldn't be able to issue dividends.

Banks that don't pay dividends could wind up being nationalized by the government. Daiwa and other Japanese banks issued preferred shares to the government in 1999 in exchange for being recapitalized with public funds. Investors holding preferred shares can exchange them for common stock in a company that fails to pay dividends.

At Topix's current level, Chuo Mitsui Trust
CUTBF
would have uncomfortably low retained earnings of about 9.5 billion yen, but the rest of Japan's major banks would be better off than that, according to Commerz Securities.

Bubbles and hangovers

Yet, through the prism of a Nasdaq on its knees, American investors are increasingly given to leaps into irrational despair and worst-case scenarios. It would be irritating to see, and above all irritating to U.S.-Japan relations, if American investors started pointing fingers at Japan's banks as the culprit of any further distress to their stock portfolios.

In fact, the bursting of the Nasdaq bubble has weighed on the Nikkei and Topix indexes. It is not, however, the main reason these benchmarks are sagging, as the Japanese media often irritatingly suggest.

Japan's problems are mostly homegrown; financial, corporate and political circles share equally in the guilt. Bank managers made poor lending decisions on a grand scale. Corporate borrowers spent foolishly on excess capacity and were slow to restructure. Credit lines were rarely cut, and neither lenders nor borrowers opened their books fully to reveal the size of the bad-loan crisis. Government officials and politicians dithered for years until crafting a 70-trillion-yen bailout two years ago that obviously wasn't effective enough.

On top of all that, the Bank of Japan throughout the 1990s was too often too slow to ease monetary policy. On the fiscal side, profligate emergency public-works packages failed to provide a lasting boost to the economy. In exchange for the lifeline, though, a bloated construction industry helped keep a corrupt Liberal Democratic Party (LDP) in power. Washington, particularly the second Clinton administration, constantly pressed Japan to juice up domestic demand and thus bears some indirect responsibility.

It's up to Tokyo, with a prod from President George W. Bush, and the central banks to fix things now, before a real crisis sets in. Recent moves appear to point in the right direction.

Full disclosure

For starters, Finance Minister Kiichi Miyazawa declared the Emperor has no clothes. All that fiscal stimulus has pushed Japan's debt to around 130 percent of gross domestic product, leaving the nation's finances "near a state of collapse," he said last week. Although Miyazawa withdrew the comment after it had roiled stock and currency markets, the naked truth was at last spoken.

As damaged as the credibility of Prime Minister Yoshiro Mori's administration is, responsible LDP politicians are pressing for solutions. Yasuhisa Shiozaki, an LDP member of the House of Representatives who is influential on financial policy, told CBS News in an interview Thursday: "We cannot just let those banks go under.... I think we might need more capital to be injected."

Ultimately, Japan's taxpayers will have to pick up the tab, so another public recapitalization of the banks won't be an easy sell for an LDP that's already nervous about facing voters in July's parliamentary elections. "The finances are there to fix the problem," says Ron Bevacqua, economist for Commerz Securities. "What's been missing until now is the political will."

Miyazawa has floated a proposal to extend a government guarantee for a private-sector fund that would support the banks and the stock market. Banks would lend to the fund, which would use the proceeds to buy shares that the banks have long held in companies that are also their clients. Active purchases should support the overall stock indexes.

The banks would benefit a second way: Japan's switch to mark-to-market accounting in April means firms will have to acknowledge unrealized losses in their portfolios. But if losing shares are sold to the fund, the banks' capital bases won't take a hit. If the shares bought by the fund fall in price, the government guarantee offers protection. The idea is that the shares would rise over time and the fund would eventually sell to pay back the banks after they rid their balance sheets of bad loans once and for all.

The banks themselves are waking up to reality of stricter disclosure. Three set to merge in April as United Financial Japan Holdings -- Sanwa Bank
SANWY
Tokai Bank
TOKBY
and Toyo Trust & Banking
TTNKF
-- announced Thursday they will post losses in their fiscal year book-closing March 31 to dispose of more than 1 trillion yen ($8.3 billion) in bad loans. This amounts to increasing a write-off they'd announced earlier of 580 billion yen by an extra 500 billion yen.

The news was a key factor in reversing a 400-point slide in the Nikkei on Thursday morning. The Nikkei closed up 309.24 points, or 2.6 percent, at 12,152.83.

As with other planned mega-mergers in Japan's banking sector, investors should pay close attention to how UFJ Holdings follows through on job cuts, branch closures and other restructuring moves it has already announced, as well as profit-making strategies to be unveiled next month.

Central banks in tune

Meanwhile, local media reports and hints from Bank of Japan Governor Masaru Hayami suggest the central bank will return to its "zero interest rate policy" as early as Monday. With Fed chairman Alan Greenspan expected to announce another cut in U.S. rates Tuesday, the combined impact on the markets could be powerful.

The BOJ recently nudged down the key overnight lending rate from 0.25 percent to 0.15 percent, but a further easing from there won't provide much stimulus to the Japanese economy. "The question is: What's next?" said Richard Jerram, chief economist at ING Barings.

Jerram thinks that the hawkish Hayami is only prepared to go back to zero rates -- a policy he abandoned last August to widespread criticism -- if a deal has been cut that will force banks which take public funds and their deadbeat corporate borrowers to accept drastic restructuring and management overhauls.

But there's also a significant risk that such restructuring will exacerbate deflationary pressures in the economy. Not surprisingly, various trial balloons for tax cuts, inflation targeting and yen depreciation are being floated. "Without some sort of stimulus while companies cut costs and prices fall, a lot of firms would go bust that shouldn't," Jerram said.

Bearish outlook for yen

The yen has already weakened to 20-month lows against the dollar. The Nikkei's rebound helped Japan's currency firm a bit, to 120.61-64 yen to the dollar at the end of the Tokyo trading day from 120.90-94 yen at noon.

Senior Japanese finance officials have been dispatched to Washington in advance of Monday's summit there between President Bush and the lamest of political lame ducks, Prime Minister Mori. The summit is about protocol not substance; the LDP is struggling to come up with a successor to Mori, who, despite approval ratings in the single digits, has managed to survive a couple of no-confidence votes in parliament.

Japanese political sources say the meetings in Washington ahead of the summit have broached the issue of exchange rates and the Bush team's tolerance of a weaker yen.

The Bush administration, trying to draw a contrast to its predecessor, has said it will not publicly lecture Japan on its economy. Treasury Secretary Paul O'Neill, formerly chief executive of Alcoa
AA, -1.02%
has indicated his support for a strong dollar and has mentioned developing a dialogue with Japanese business leaders.

But at a time when there's been plenty of talk about recession, even though the U.S. hasn't slipped into one just yet, the costs of a much stronger dollar could be economically and politically high. Just when growth is needed most, a brawny buck could throw a wrench into the export engine, and American jobs could be on the line.

Bush, an advocate of free trade, could be in for an earful of protectionist rants from the likes of makers of auto parts and steel, industries that have clashed with Japan before.

Bush should turn a perfunctory summit to his advantage. He should honor his free-trade credentials by urging Japan to promote structural reforms as well as deregulation that would increase competition between U.S. and Japanese firms. He should emphasize the need for speed in cleaning up the banking mess. There's no need for the administration to say anything about the dollar because it will find near-term support from a fresh Fed rate cut anyway.

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